What was contracting out?

What was contracting out?

Under the old state pension rules, you were able to 'contract out' of the additional state pension.

Contracting out ended in April 2016, but your contracting-out history will still impact how much state pension you get under both the old and the new system.

In addition to the basic state pension, the state previously provided a second-tier top-up pension, based on how much you earned - the additional state pension. Introduced in 1978 and originally called the state earnings related pension scheme (Serps), it became the state second pension (S2P) in 2002.

Before the rules changed in 2012, employees were allowed to 'contract out' of this additional pension. In exchange for lower or redirected National Insurance contributions, they gave up part or all of it and received extra pension from their occupational scheme or personal/stakeholder pension instead.

Until 1988, people could only contract out if they were members of a defined benefit (DB) occupational pension scheme. In 1988, the government extended this to defined contribution (DC) or money purchase occupational schemes and personal pensions.

For the first five years of the scheme, the government paid an extra 2% of your earnings into your personal pension. By 1992, more than 5 million people had left Serps for a personal pension.

Here's what you need to know.

If you were contracted out of a defined benefit scheme

If you were in a contracted-out defined benefit (DB) scheme, you and your employer paid a slightly lower National Insurance (NI) contribution. This reflects the fact that neither of you contributed to the state additional pension. From April 2012 to April 2016, only those in a defined benefit (DB) scheme could be contracted out and paid a lower rate.

If you were contracted out through a DB scheme, you were promised a certain amount of pension, in place of the additional pension you were giving up. Contracting out on a DB basis ended in April 2016, when the government's state pension reforms came into force.

If you were contracted out of a defined contribution scheme

From April 1988 to April 2012, employers were allowed to contract people out into defined contribution (money purchase) occupational schemes.

If you contracted out through an appropriate personal pension (APP) or appropriate stakeholder pension (ASP), you and your employer paid the same NI contributions as before, but some of this was rebated.

This amount was known as your NI rebate. Tax relief was added to the rebate, and this total amount was invested, and at a retirement date was used to provide benefits called 'protected rights'

In April 2012, those in a defined contribution (DC) scheme were contracted back in and paid National Insurance at the full rate. They accumulated state second pension (S2P) between 2012 and 2016.

What were protected rights?

In 2012, when contracting out was abolished for DC schemes, members' 'protected rights' were converted into ordinary pension benefits.

Protected rights were the benefits which a contracted-out DC scheme had to provide for members.

A member's protected rights were made up of the amounts the employer saved as a result of reduced NI contributions and HMRC age-related rebates. Schemes contracted-out on the protected rights basis had to comply with various statutory conditions.

These conditions included:

• Protected rights had to be separately identifiable
• A retirement pension that can be paid from age 55 onward to be paid through an annuity or income withdrawal
• Annuities deriving from protected rights had to provide a survivor's pension where the member was married or in a civil partnership
• A pension for your spouse or civil partner if you die before retirement

What does having been contracted out mean for my state pension?

People qualifying for the state pension before 6 April 2016 will get less or no additional state pension if they've spent time contracted out, and those qualifying on or after 6 April 2016 will get a lower 'starting amount'.

Defined benefit schemes and guaranteed minimum pensions

The guaranteed minimum pension (GMP) is the minimum pension which an occupational pension scheme provided for those employees who were contracted out of Serps between 6 April 1978 and 5 April 1997.

The GMP calculation is complex and is based on contracted out earnings (ie earnings between the lower and upper earnings limits) for each year of contracted out service.

Different rules applied to GMP annual inflation-linked increases in two distinct periods - 1978-1988, and 1988-1997. This means the GMP can rise at different rates depending on when you built up the additional pension.

For service before 1988, there is no duty on your scheme to provide inflation-linked increases, whilst for service between 1988 and 1997 they have to provide inflation-linked increases up to a cap of 3%. The DWP then recalculated the state pension payable each year, which makes sure that a person's guaranteed minimum pension entitlement is up-rated.

After 1997, the law changed. There were still minimum pension benefits that an employer needed to provide if you wanted to contract out. However, instead of GMPs, the scheme had to meet a 'reference scheme' test. That is, the scheme had to provide benefits at least as valuable as those that you would get as a member of a reference scheme set out in law.

For people retiring after 6 April 2016, the government decided, somewhat controversially, to no longer cover part of the inflation increases to guaranteed minimum pensions (accrued between 1988 and 1997) when up-rating people's new state pension.

In effect, this means that guaranteed minimum pensions will not be increased fully via the state pension.

Defined contribution pension performance

Unlike defined benefit schemes, there is no guarantee that your eventual pension will match or beat what you would have received if you'd stayed with the state second pension.

The final amount depends on the performance of your investments in the pension into which your rebates were diverted.

However, the fact that the money was placed into a defined contribution scheme means that you can benefit from the greater flexibility of the pension freedoms, with the option to access your money at the age of 55 (rising to 57 in 2028).